Commercial Real Estate Rents on the Rise

Shopping centers and office towers that sat empty and unlighted during and after the recession are slowly being put back into use. Along with the rest of the national economy, rents for commercial space hit the skids during the severe 2007-2009 contraction. Now a slow but steady revival means rents will rise about 2.25% on average in 2014, after climbing about 2% this year. Nearly three years of unbroken monthly job creation has left shoppers better off and businesses looking around for warehouse space that will allow them to stock up inventories.

Boom conditions they’re not — certainly the improvement isn’t enough to trigger another construction surge. But the situation is a great deal better than from 2009 to mid-2011, when industry discussion focused on how much rents had to be cut to keep any occupants in commercial buildings. The upswing is not evenly distributed, either, especially for retail space. Consumer demand has not rebounded equally and some big urban areas — Los Angeles on the West Coast and New York on the East Coast, for example — are seeing big rent increases. Meanwhile, commercial real estate in other regions continues to languish.

Still, “a rising tide lifts all boats,” as Phil Jemmett, a commercial loan expert and CEO of Breakwater Equity Partners in San Diego, says. “The further the Great Recession retreats into our past, the more accurately we can see that the recovering economy is lifting the commercial real estate industry. The end of 2012 marked an inflection point and we have subsequently seen steady improvement.”

After increasing an average of 2.6% this year, top-flight office space will cost about 2.8% more next year — more on the coasts, where businesses cluster and legal, banking and other business service industries bid for the classiest buildings and premium locations.

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Not long ago, a savvy businessman could snag the best space, Class A, for a song, just because its owners desperately needed the income. Those days are gone. Such top-quality space in primary markets such as New York and Los Angeles has now reached its potential, according to Jemmett. He says, “Deals that were available 18 months ago are absolutely, categorically out the window now.” Even in popular smaller markets —such as Austin, Texas — rents are following that upward trend.

But that’s not true everywhere. Some large markets like Phoenix are struggling to reduce vacant space due to overbuilding ahead of the recession and to jitters about the business climate while political issues like immigration reform are on the front burner. So tenants still have a strong hand in setting rents.

Though the dynamics are different, the pricing trends for warehouse rentals are similar to that of office space: up about 2.6% in 2014, following a 2.4% rise this year. Some of the upswing is driven by hope: Owners anticipate that businesses will feel more confident now that Europe is easing out of recession and the slower growth trend in China is stabilizing. Landlords anticipate businesses will need space to store larger inventories of finished goods.

Declining vacancy rates for industrial property in areas where exporting occurs — Orange County, Calif., Los Angeles, Miami and Seattle, for example — seem to corroborate landlords’ optimism. El Paso, Texas, also is experiencing warehousing demand, stemming from its strategic location as an export point to Mexico and elsewhere in Central America.

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The outlook for retail space rents is more muted. Although consumers have benefited from increased job creation, income growth has been restrained. Rising home prices have helped sustain consumer optimism, but that feeling is fragile because of worry about deficits, taxes and virtual political gridlock in Washington. Look for retail rentals to edge up 1.4% this year and 2.2% in 2014.

Moreover, with retail space, location is paramount. Rents will strengthen most where consumers have the best opportunity to score solid wage gains and where home prices record the sturdiest rises. The National Association of Realtors points to San Francisco; Orange County, Calif.; Fairfield County, Conn.; and Long Island, N.Y., as leading candidates for bigger rent rises.

“Where projects were built at the wrong time, in the wrong place” according to Jemmett, the retail real estate market isn’t showing signs of improvement. Others, built at the wrong time but in popular shopping areas, are on the road to recovery. “Even smaller investments, such as strip centers, are in high demand if they are well positioned geographically, ” he notes.

Because so much retail building occurred in late stages of the prerecession boom — in 2004 and 2005 — there is more overhang to be worked through in this sector than in any other. In addition, many entrepreneurs who gambled on retail projects and suffered years of lean tenancy afterward, financed them with 10-year loans. Those loans will need to be rolled over in the next few years, just when interest rates are beginning to rise in an expanding economy. That will up the pressure on owners who must carry the cost, and potentially also on their tenants, who will likely face continuing rent hikes unless they have locked in long-term leases.